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Garrett Johnson

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The Crowning Failure of the Old Governments

Posted: 10/13/10 03:55 PM ET

The world's leaders gathered in Washington last weekend to try to address the global imbalances that continue to weigh on the economies of the world. It didn't go well.

The IMF meeting, meant to lay the foundation for some greater co-operation on the co-ordination of national economic policies, instead ended in mutual recrimination. And that has made it harder to reach agreement at the gathering in Seoul next month of the Group of 20 industrialized and developing nations.

The heart of the disagreement is the "international currency war," as Guido Mantega, the Brazilian finance minister, called it three weeks ago. The media has focused on the verbal spat between America and China, but the beggar thy neighbor policies are being waged by dozens of nations around the world.

What I find surprising is that so far the media has failed to recognize how familiar this scenario is.


77 years ago H.G. Wells wrote the fictional book The Shape of Things to Come. He made a number of predictions, a significant number of them came true. His most notable prediction was the start of World War II beginning in January 1940 in a military clash between the Germans and Poles at the port of Danzig, which eventually drags in France and the Soviet Union.

He was only off by three months.

A mostly forgotten part of the book referred to his present day events in a chapter called "The London Conference: the Crowning Failure of the Old Governments."

The men who assembled had just as good brains as anyone to-day, and... they had a substantial understanding of the needs of the world situation, yet collectively, and because of their haunting paralyzing sense of the Mass and Press behind them and of their incalculable impulses and resentments, they achieved an effect of fatuity far beyond the pompous blunderings of Versailles.

Wells uses the London Conference as an inflection point where the world leaders failed to stop the globe from drifting down a path that could only lead to disaster.

What was the purpose of the London Conference? To fight the global depression and revive international trade by stabilizing global currency exchange rates.

Next month the world's leaders will meet in South Korea. Their main purpose will be to prevent the international currency war, which is just another term for "trade war", from escalating further, and to stabilize global currency exchange rates. Because of the failure of the recent IMF meeting there is no agreement on how to achieve those goals.

In 1944, exactly 11 years after the failure of the London Conference, with the end of World War II in sight, the world leaders gathered at Bretton Woods, New Hampshire. Fully aware that the failure of the global economic system following WWI was responsible for the rise of fascism and WWII, they set up the Bretton Woods System.

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value--plus or minus one percent--in terms of gold and the ability of the IMF to bridge temporary imbalances of payments.
The next couple decades saw in incredible burst of global economic growth and world trade.
The system only had one flaw - it required the United States, the holder of most of the world's gold in 1944 - to maintain fiscal restraint. The immense amount of money spent on a useless war in Vietnam doomed it. On August 15, 1971, President Nixon broke the dollar's convertibility to gold. The Bretton Woods system was over...sort of.

"We must rethink the financial system from scratch, as at Bretton Woods."
- French President Nicolas Sarkozy, 2008

What arose in its place has been called Bretton Woods 2.

Similar to the original Bretton Woods, this included Asian currencies being pegged to the dollar, though this time by the unilateral intervention of Asian governments in the currency market to stop their currencies appreciating.

The collapse of global trade in 2008-2009 saw America's chronic trade and current account deficit dramatically shrink. But the shaky stabilization that followed has witnessed a return of huge trade and current account deficits. Nothing has been fixed.

Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $). That mean that the increase in imports was 87.5% of the increase in domestic demand.

To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%. It does not take some great new "freshwater" theory to explain why the stimulus is not working as expected, simple old fashioned Keynesian models explain it adequately.

To put it simply, 87.5% of the money the government borrowed to "fix" the economy went directly overseas to east Asia. Is it any wonder why the domestic employment situation doesn't improve?

When other nations go through a severe economic crisis, their currencies usually depreciate to the point that their domestic production becomes temporarily hyper-competitive. This makes it easier to replace imports with domestic products.

In stark contrast to the rest of the world, a severe crisis has people rushing to the dollar. Our currency actually gets stronger, and our domestic products get less competitive, when a financial crisis strikes.

Obviously, chronic high unemployment is incompatible with a global economy that depends on the United States buying their consumer products.

It gets worse. Wall Street bonuses are expected to break another record this year - a mind-boggling $144 Billion. That's a 4% increase over last year's record.

If you add the amounts of real imports and Wall Street bonuses and subtract that number from real domestic consumption, you get a negative number for Main Street and the real economy.

Bretton Woods 2 is already failing. In Bretton Woods 2, the Wall Street TBTF banks act as intermediaries between foreign savers and American consumers. After the 2008 collapse, Wall Street stopped lending to Main Street.

Thus the U.S. Government and Federal Reserve stepped in by trying to keep stock, bond, and housing bubbles inflated. The mortgage market is now totally a U.S. Government mandate and subsidy.

Perhaps we should call the present system Bretton Woods 2.1.

If Bretton Woods 2 was unsustainable, Bretton Woods 2.1 is even more unsustainable. It requires the government to borrow immense amounts of money to prop up domestic consumption that directly benefits foreign producers. The government bailouts are like pumping blood into a corpse in the hope that it might walk again.

On the surface, this temporary bridge looks much like the period between August 1971 and February 1973, when the Bretton Woods currency exchange markets finally closed.

Washington is gridlocked. Even proposals for extending existing unemployment benefits in an economy with a 10% unemployment rate is doubtful.

The system is broken.

That only leaves monetary policy from the Federal Reserve, and they are preparing to crank up QE2.

Ben Bernanke has no sure fire policy solution for economic stagnation. QE2, the $1 trillion quantitative easing expected, hoped for, prayed for, gossiped about, will only pour money into an economy that has no use for it. There is already $1.8 trillion cash on corporate balance sheets, $2 trillion cash in money market mutual funds and over $1 trillion reserves in commercial banks- a total of $4.8 trillion unused cash sitting silent. Creating no jobs, no consumer purchases.

QE2 will have a boomerang effect on the middle class. It will raise the price of wheat, sugar, coffee, poultry, beef, pork, raising their cost of living, reducing their disposable income. Just the opposite that Bernanke intends.

QE2, also known as quantitative easing two, a fancy term for money printing, will have negative effects and everyone knows it. China was particularly vocal about it at the IMF meeting.

Zhou Xiaochuan, central bank governor, and ironically the strongest advocate within China's governing agencies of faster renminbi appreciation, charged that expectations the US Federal Reserve would pump yet more dollars into the markets through quantitative easing was worsening imbalances and swamping emerging economies with destabilising capital inflows.

Increasing the monetary supply of dollars has a multiplier effect with every nation that is trying to debase their currencies against the dollar (i.e. most of our trading partners). In order to debase their currencies they need to match our currency printing with their own. That money has to go somewhere. In China's case, that means they are likely to see a further expansion of a massive domestic housing bubble.


QE2 might just be the catalyst for the end of Bretton Woods 2. That result would bring with it the end of the dollar as the world's reserve currency. Without a plan, this would leave the world's financial system in a chaotic mess.

The massive overproduction of consumer goods in Asia has a deflationary effect on the price of things we want. This balances out the inflationary effects of the money printing.
However, when it comes to things we need, like food and other commodities, there is no overproduction. The cost of living will rise.

The weak U.S. dollar helped crude oil to rise above $84 a barrel to a five-month high before it eased, while copper hovered just under two-year highs as investors snapped up commodities on the prospect new money will boost asset prices.

This is a good example of the problem with the current policy solutions. The government is focusing enormous resources trying to keep asset bubbles inflated, and the price of things we want low. This is misdirecting resources away from things we need.


Some people point to low interest rates on bonds as a sign that there is no inflation expectations. In reality it only means that investors are trying to front-run the Fed and purchase bond assets that the Fed is sure to buy in massive amounts under their QE2 program.

Besides creating an environment of begger-thy-neighbor, QE2 is going to make the world's poor suffer. The rise in food prices corresponds almost perfectly with Bernanke's announcements of future monetization. The rise in food prices is starting to get critical.

So far in 2010, the price of crude oil has jumped by 27%, of corn by 63%, of wheat by 84%, of sugar by 55%, and of soybeans by 24%. Without the Fed's unprecedented loose monetary and near-zero interest rates, it would have been highly unlikely for commodity prices to increase at these alarming rates.

Ambrose Evans-Pritchard says that the debasement of the currencies is the cure "albeit a bad one". I have a hard time picturing a solution where millions of poor people starve as being a "solution". Especially when Wall Street bankers are still getting multi-million dollar bonuses after causing this catastrophe.

I think people need to start thinking outside the box for a better solution. Maybe there is no innocuous fix, as Krugman put it, but making the poor pay for the sins of the wealthy is morally repugnant and is not a solution I will consider.